The LM Curve (belonging to the IS-LM model ) shows the geometric place in which there are all combinations of income (Y) and nominal interest rates (i) for which the money market is in equilibrium.
This balance in the money market represents a situation in which all the money that is demanded (L (i, Y)) in an economy, equals the money offered in that economy (M / P), that is M / P = L (i, Y).
The LM curve (known by its acronym in English Liqudity preference and money supply equilibrium) has a positive slope, given that there is a positive relationship between the level of income and the demand for money. If the level of income rises (for the same interest rate and for a rigid money supply) the public demands more money to carry out more transactions, therefore, so that there is balance in the money market, the interest rate has to rise.
LM curve calculation
The LM curve is formulated by the following expression:
M / P = L (i, Y)
M: Monetary amount in the economy.
P: Price level of the economy.
L: Demand for money in the economy.
i: Nominal interest rate.
And: Income level of the economy.
The increases in income (under the assumptions discussed in the previous paragraph) are the ones that gradually increase interest. The union of these points determines the curve. For the LM curve, we consider the nominal interest rate as an independent variable and the income level as a dependent variable. Depending on the sensitivity of the demand for money at the interest rate, we will have a more or less pronounced slope. If the sensitivity of the demand for money with the interest rate is high, before a rise in the product we will have a small increase in the interest rate and vice versa. Therefore, a higher / lower sensitivity, lower / higher slope.
Meaning of the LM curve
As is well known, central banks use the money supply in their policies to influence the pace of the economy cycle. The money supply determined by the bank has a direct effect on interest rates. Suppose that the central bank of any country wants to cool the economy of a country (that is, slow down the expansionary cycle in it).
LM curve example
If the central bank reduces the money supply (assuming price stability) accordingly and to satisfy the model equation, the interest rate will rise. This will cause the cost of borrowing to be higher and the investments of the country’s economic agents to be more burdensome. Therefore, the fall in investment will result in a reduction in the level of income, thus cooling the economy cycle.
The LM curve in the IS-LM model
When the LM curve is combined with the IS curve, the point at which the IS and LM curves intersect shows the position of the simultaneous equilibrium in both the monetary and the goods markets . It is a stable equilibrium because if there is a temporary imbalance situation that moves the position to any other point, market forces will press to return to that crossing point.